Hindsight is a wonderful thing, but sadly unavailable to investors. Had your crystal ball been operating at the beginning of 2018 you could have done no better than to bet against the Shanghai A-share market and put the proceeds into America’s tech-heavy Nasdaq index. The former has fallen by about 15pc in the first six months of the year while the latter rose by 20pc.
It is unlikely that many people came close to this divergent strategy. A momentum investor would six months ago have looked at both the US and Chinese markets and stuck with them after 2017’s strong rally. A contrarian, meanwhile might have looked at the valuation of Wall Street and the stellar performance of the A-shares and bet against both. Rationalising what markets actually do is a great deal easier in the rear-view mirror than looking straight ahead.
The first six months of this year have been difficult for investors. Broadly speaking, all the things we keep an eye on have got a bit worse. Growth has slowed, inflation has picked up, monetary policy has tightened. The result has been lots of volatility and not much progress other than in pockets like the FAANGs, which have become the new consumer staples for defensive investors. Your performance this year has very largely been a consequence of whether or not you invested in Apple, Amazon and Facebook and placed a bet on a rising oil price.
Leaving the Nasdaq and Shanghai outliers aside, markets have mainly gone sideways. The FTSE 100 has had a rollercoaster ride but ended June almost exactly where it started January. The S&P 500 is up by a handful of percentage points. Japan and Europe have fallen by the same narrow margin. Dragged lower by China, emerging markets have had a half year to forget, down by a tenth.
This pause for breath is explained by a two-way pull on investor sentiment that’s left investors scratching their heads about where markets go next. With unemployment at multi-decade lows, tax cuts feeding through to powerful earnings growth for US companies (even if profits are rising rather more slowly elsewhere) and valuations bang in line with the long-run averages, it is still possible to make a case for owning shares. The absence of plausible alternatives for your long-term savings reinforces the bullish case.
But the list of headwinds is long and daunting. Top of these is the rapid deterioration in the global trade outlook. Donald Trump’s reckless unpredictability on this front is unsettling. The President either doesn’t understand or doesn’t care about the impact of his unilateral assault on globalisation. The fate of Harley Davidson, the iconic manufacturer of American motorcycles, is the perfect illustration of the unintended consequences of his America First protectionism.
This most American of companies has and will be hit first by rising costs as a result of the tariffs on imported aluminium and steel, second by the EU’s retaliatory tariffs and third by the inflation and job losses that will inevitably follow. The deteriorating trade position goes a long way to explaining why US small caps have outperformed America’s blue-chips (they are much more domestically-oriented) and why Europe and Japan, with their dependence on exports, have been such a disappointment so far this year.
The second key headwind is oil. Again, Mr Trump must accept at least some of the blame for the recent surge in the price of crude. The resumption of sanctions on Iran is not the only reason oil has hit a four-year high but, at the margin, the loss of one of the Middle East’s most important producers means Saudi Arabia and Russia’s agreement to open the taps a bit may be too little too late in an increasingly tight market.
Stock markets tend not to turn downwards unless recession is on the cards. Six months ago, that was no-one’s base case. Trade tensions and a higher oil price make it altogether more likely today. The supporting evidence for this is a flattening yield curve as rising short-term rates are not matched by longer-maturity bonds where yields are held down by growth fears further out.
The third major challenge for markets this year has been the progressive tightening of financial conditions. This is most obvious in the US, where interest rates are seemingly on a steady upward trajectory. But the more important tightening may well have taken place in China. This, rather than trade, is the real reason why the Shanghai and Shenzhen markets are now in bear market territory, having fallen by more than 20pc from their January highs.
There are echoes of the plunge in the Chinese market in 2015 when a depreciating renminbi threatened to trigger capital flight. Beijing seems happy to let its currency slide for now to offset the impact of Trump’s tariffs by making Chinese exports more competitive. Whether it can step in to halt the decline when it wants to remains to be tested.
Credit conditions are tightening in China as the authorities move to impose more regulation in the banking sector and clamp down on dodgy shadow lending via asset managers. Growth in retail sales, residential property prices and fixed asset investment is heading south. These effects were all evident long before the US turned its attention to its yawning trade deficit with China.
The final headwind is political uncertainty on either side of the Atlantic. Angela Merkel’s position remains shaky despite last week’s last-minute migration deal, the Brexit doomsday clock is ticking and the American Mid-Term elections loom.
With all these unresolved questions, I expect the second half of 2018 to be as interesting as the first. While we wait for hindsight to tell us how the full-year pans out, the case for a broadly-diversified (and defensive) portfolio has never been stronger.
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Tom Stevenson
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